Decentralized Decision Making in Investment Management∗

We study the investment problem of a pension fund, which employs multiple asset managers to implement investment strategies in separate asset classes. The Chief Investment Officer (CIO) of the fund allocates capital to the managers taking into account the liabilities of the fund. The managers subsequently allocate these funds to the assets in their asset class. This organizational structure relies on the premise that managers have specific stock selection skills that allow them to outperform passive benchmarks. However, by decentralizing asset allocation decisions, the fund introduces several inefficiencies due to (i) reduced opportunities to manage mismatch risk, (ii) a loss in diversification, and (iii) imperfectly observable appetites for managerial risk taking. If the CIO compensates the managers using cash benchmarks, the information ratio required for each active manager to justify this organizational structure ranges from 0.4 to 1.3. However, we derive optimal benchmarks that substantially mitigate the inefficiencies, while preserving the potential benefits of active management. The optimal performance benchmarks reflect the risk in the liabilities. We therefore develop a novel framework to implement liabilities-driven investment (LDI) strategies